The traditional investment analysis construct is either flawed or quite inefficient. As noted on the front flap of the book jacket for Expectations Investing, by Alfred Rappaport and Michael Mauboussin:
“About 75 percent of all investors deliver returns below those of passive funds. Why? In part, it's because proven methods for valuing assets are too complex to apply—causing investors to rely on commonly used benchmarks such as current price-earnings multiples that simply don't reflect how the market prices stocks”
Profitability Analysis
The traditional profitability analysis, used by most investors for evaluating the profitability of a company, employs financial information from the Income Statement as published by all publicly-traded companies every 3 months in their earnings press releases. Though companies provide much more pertinent information, most investors do not have the time or incentive to assess information from the company's balance sheet, other financial statements or, most importantly, the Notes to the Financial Statements. For the most part, only the income statement is read closely and used by analysts to create “earnings models.” The earnings models simply use formulas programmed within Microsoft Excel to recalculate the numbers in press releases, 10-Qs or 10-Ks for historical analyses. In turn, these historical analyses are extended forward to aid analysts in forecasting earnings. 10-Qs and 10-Ks are the formal names of the quarterly and annual financial statements that the Securities and Exchange Commission require companies to publish within 90 days of the end of the reporting period. This process explains how analysts or analyst teams arrive at earnings estimates. The basic process analysts use to evaluate profitability of publicly traded companies is as follows. A company issues a press release with its quarterly earnings report, including income statements for the most recent quarter. Analysts use the data in the income statement to update a model, which is structured based on the income statement in the press release. Analysts then make presumptions to forecast revenue growth and profit. Assumptions are built on historical results as recorded.
Disproportionate Focus on Earnings and Earnings Per Share (EPS)
The large majority of investors rely on earnings or earnings per share (EPS) to evaluate the profitability of publicly traded companies. As noted above, this data is fairly easy to access, model and compute since it comes directly from companies in the form of an income statement in press releases, 10-Ks or 10-Qs or financial data aggregators like FirstCall. We will refer to the data that come directly from the Income Statement as “reported,” e.g. reported earnings. There are many potential adjustments to reported data, but very few that are applied consistently. The large majority of investors focus their analytical efforts on the accounting metrics as reported. Those adjustments to these accounting numbers that are applied consistently (e.g. operating earnings) provide little reparation to the distortion from cash flow that accounting metrics present. The main problem with relying on reported numbers that SEC financial documents were designed by accountants for credit analysis rather than investors for investment evaluation. There are entire books devoted to delineating the shortcomings of accounting metrics, however, a few are detailed herein. The income statement and balance sheet from press releases, 10-Qs and 10-Ks do not reflect:                True cash flow of the business        True operating profit of a business        True liabilities of a company        True costs of employee compensation        Capital costs required to generate the earnings        
All too often, the income statement includes non-operating gains and losses that obfuscate the normal cash flow of the business. In addition, the income statement is prone to many other accounting distortions that companies exploit in order to “manage their earnings.”
In summary, earnings are useful only as a proxy for cash flows. When cash flow and earnings diverge, earnings are useless. Unfortunately, too many investors operate blind to this fact and make themselves and their clients are vulnerable to undue investment risk. Other common accounting profitability measures (ROE, ROA) are based on earnings. If one starts with a bad assumption (i.e. that earnings are true measure of profitability), it is easy to see how use of these measures may lead to distorted results. Most other accounting metrics (e.g. Debt/Equity, Current Ratio, etc.) used by investors are not performance measures. They are intended to aid accountants and credit analysts in performing other tasks besides valuation.
Traditional Valuation Expects Too Much from Multiples Analysis
When investors base their valuation analysis on a business' profitability, they have the correct intention. Unfortunately, flaws in the large majority of analysts' profitability assessments cause their valuation to be flawed. For example, a price-earnings ratio (P/E) divides a company's stock price per share by is earnings per share (EPS) and, as a consequence, falls victim to the accounting distortions of EPS. Any valuation methodology that builds on a poor assumption is flawed.
It is no secret that earnings and EPS provide poor insight into the true profitability of businesses. Many investors use valuation multiples of other proxies for cash flow such as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) and EBIT. However, these measures, despite the ease with which investors may calculate them, are prone to many of the same distortions of other accounting metrics. Though they can alleviate some accounting distortion, they are not accurate representatives of the true cash flow of a business. Accordingly, the price-to-revenues ratio moves the valuation process even farther from the economic profitability of a business as a business' value in this construct is based on its revenues with little or no attention paid to the profits it may or may not derive from those revenues.
Another common valuation multiple is the Price-to-Book Value ratio. This ratio does not even attempt to value the company based on its cash flows. Even so, the book values analysts use are often an inaccurate assessment of the equity invested in the company. The traditional valuation process is an extension of a flawed profitability evaluation process, as follows. A quarterly earnings report, as represented in a company-issued press release presents earnings results for the most current quarter. These include, or may be used to readily calculate earnings, EPS, and ROE. Analysts update their earnings models based on the reported information. The analysts structure their models based on the income statement in the press release, and employ the Earnings, EPS, and ROE. The analysts then develop forecasts, based on assumptions for revenue growth and profit. Assumptions are built on historical results as recorded in the model. Analysts then perform a valuation by applying stock price multiples to accounting metrics such as EPS, EBITDA or book values, to yield such calculated metrics as P/E, Price/EBITDA, Price-to-revenues multiple, and the like.
In essence, valuation multiples are short cuts to proper discounted cash flow (DCF) analysis. They are useful only by comparison to comparable companies, but do not provide an adequate substitute to assessing the lifecycle cash flows of a business. Other less popular measures, such as EVA and CFROI, offer improved cash flow analysis but are not alternatives to the proper discounted cash flow (DCF) valuation process either.
Most DCF Analyses are Flawed
Those investors that do use DCF analysis tend to do so incorrectly. The most common mistake is that investors arbitrarily apply a five or ten year forecast horizon to the lifecycle of a company's future cash flows. Though five or ten years may be appropriate for some businesses, it is certainly not applicable to most. Forcing all DCF analyses into 5 or 10-year frameworks is much simper than building separate frameworks for every company. Most investors add a terminal multiple to the present value of the five or ten-year forecasted cash flows. These terminal multiples fall prey to the same deficiencies as the multiples described above. In fact, most of these terminal values are usually based on a P/E or Price-to-EBITDA multiples. In essence, traditional DCF analyses reflect an attempt by analysts to combine simpler valuation tools. The result is a more complicated valuation process that produces little if any incremental insight since they are, in essence, extensions on poor original assumptions. In addition, most investors use DCF models to compute target prices based on their assumptions for the company's growth and profitability. Like a shot in the dark, these assumptions are often made in a total vacuum with no comparison to the assumptions embedded in the stock price. Lastly, analysts all too often do not discount true cash flows. Instead, they use an accounting approximation.